Big Guns Aim for Change

More investors are taking action in a wide revolt against errant companies

June 24, 2002, 12:00 AM EDT

As head of North Carolina's Crime Control & Public Safety Dept., Richard H. Moore led recovery efforts after two destructive winter storms and five hurricanes. But little had prepared him for the financial firestorm he faced after he became state treasurer in 2000, as executive greed torched trust in Corporate America and reduced one marquee company after another to ashes. The sole fiduciary of North Carolina's $60 billion state pension fund began to grill money managers about how they looked after the interests of the 600,000 cops, teachers, and other state employees in the fund. And the more he learned about deceptive analysts, conflicted money managers, and self-serving corporate execs, the more alarmed he became.

Now, Moore is swinging into action. He's planning to refuse to deal with Wall Street firms that won't voluntarily adopt reforms like those imposed on Merrill Lynch & Co. as part of its $100 million settlement with New York Attorney General Eliot Spitzer. "I'm not trying to supersede anything Congress does," says Moore. "I'm just a consumer in the marketplace, and I happen to be a large consumer."

Score one for Adam Smith and the power of the market. With Congress gridlocked on reform legislation and business leaders hostile to a major overhaul of corporate governance, institutional investors such as Moore are the last line of defense. They have the firepower: Pension and mutual funds have nearly $8 trillion riding on the stock market today, a massive 65% of its value, vs. 51% in 1990. All they need is the will to use it. And a growing army of state and private pension funds, mutual funds, hedge funds, foundations, and labor unions is outraged enough to do so. "What's going on now is the ugly, dirty side of capitalism," says Desmond J. Heathwood, CEO of Boston Partners Asset Management, a fund company with $10 billion in assets. "We've got to clean it up."

Traditionally, institutional investors have voted with their feet--by selling off the stocks of companies they don't understand or whose managements they don't trust--because they're leery of offending companies whose billions in pension and 401(k) funds they manage. Dumping of shares still happens regularly, of course, and on occasion, it can turn into indiscriminate slaughter. Witness the hammering cable-TV stocks have taken since Adelphia Communications admitted in June that it had exaggerated subscriber numbers.

But what's different this time is that mainstream money managers who once blanched at such a prospect are getting down and dirty with company managements. Before, such fights were the preserve of longtime activists such as the California Public Employees' Retirement System (CalPERS) and TIAA-CREF, the teachers' pension fund. And like these trailblazers, the new activists are increasingly homing in on individual companies. They grill execs privately and in public, launch attacks through proxy contests on issues ranging from executive pay to the independence of board members, and even sue for fraud. "You can't [just] vote with your feet," says Chris Davis, a third-generation money manager who oversees $35 billion at New York family investment firm Davis Selected Advisors. "You really have to work on changing the system."

Davis has been bearing down on blue-chips such as McDonald's (MCD
), General Mills (GIS
), and SBC Communications (SBC
), arguing that they're giving away far too much shareholder wealth in stock-option programs. But there's a limit to what meeting with directors, writing letters to management, and talking with CEOs--the tactics Davis and others use--can achieve. "When companies as conservative as SBC and General Mills become infected [with poor practices], there is no place to run," he says. "We're going to have to go to the next step."

That step could turn into a giant leap for institutional investors. Davis is putting together a group who together manage $500 billion to $1 trillion, or nearly 10% of the stock market. They will target companies in the Standard & Poor's 500-stock index on corporate-governance and executive-compensation issues. Warren E. Buffett, the legendary Omaha investor; Bill Miller, star manager of Legg Mason Value Trust Fund; and John C. Bogle, founder of the Vanguard Group and father of index investing, have signed up. This year, Miller refused to vote for management's slate of directors at credit-card giant MBNA Corp. (KRB
) because they repeatedly handed out new options to execs. And the giant Fidelity Investments mutual-fund family, though not an acknowledged member of the group, said on June 11 that it may deliver a similar public slap in the face to directors who approve overly generous executive-compensation plans.

Much more is at stake than the money and careers of the heavy hitters. Unless confidence returns, billions more will disappear from the stock market wealth of millions of investors, along with the livelihoods of tens of thousands of financial-industry employees. Businesses and innovators will face higher financing costs. And the ability of the U.S. to attract all of the foreign investment it needs will be seriously impaired. "It's troubling when you've got a recovering economy and a market that's going in the wrong direction," says Michael Carpenter, Chairman and CEO of Salomon Smith Barney.

Investors' disillusionment has also cast a pall on lucrative mergers and initial public offerings. So investment banks and brokerages have donned the mantle of reform. They are issuing more downgrades and embracing much tougher systems for rating companies in a scramble to prove to investors that they are not beholden to investment-banking clients. They're also urging companies to meet investors' new demands for clean balance sheets by divesting operations and getting rid of assorted minority investments.

The besieged bankers have a strong motivation: Their business won't start humming again until millions of betrayed investors flock back to the stock market. "Our business is trust, and when that trust is impaired, any management of a responsible financial institution wants to change as fast as possible to restore it," says Philip J. Purcell, chairman and CEO of Morgan Stanley Dean Witter & Co. "I think you'll see financial companies move to standards well above what's being required by regulators, legislators, and industry organizations. If anything, the financial system has to overcorrect."

Certainly, the New York Stock Exchange and Nasdaq are on fast-forward. They are falling all over themselves to prove that they offer superior protection to long-term investors. The exchanges started issuing new corporate-governance rules--the first major overhaul in nearly five decades--after a request from Securities & Exchange Commission Chairman Harvey L. Pitt in February. But now, they're racing ahead of him. The NYSE wants company boards to have a majority of independent directors and to put options schemes to a shareholder vote. The Nasdaq is playing catch-up--and wants even more new rules. For example, it's proposing that directors whose charities receive large donations from their companies should be thrown off audit committees. Not to be outdone, the NYSE would have the SEC ban companies from issuing now-notorious pro forma earnings before they report their actual results according to generally accepted accounting principles (GAAP). "Some of the stuff in these plans is pretty bold. Under other circumstances, these changes would be impossible," says a senior SEC official.

Of course, if the stock market rebounds strongly, Wall Street's newfound enthusiasm for reform could fade rapidly. Moreover, while talking about new rules is easy, putting them into practice is a much tougher proposition. For now, ferocious lobbying--and generous campaign donations--by business and accounting firms have stymied reform legislation in Congress.

Still, institutional investors have forced dramatic change on Wall Street in the past. In 1969, they blasted brokerages for a massive debacle in handling paperwork that resulted in their trades not being processed for days or being lost entirely. Their fury eventually fueled legislation that ended brokerage houses' fixed commissions in 1975 and changed the face of Wall Street for good. This time, their impact will be felt far beyond the financial-services industry. "This is a much more far-reaching crisis of confidence," says Manhattan College finance professor Charles R. Geisst and author of Wall Street histories.

The nation's financial cops aren't about to give up easily, either. The SEC, the National Association of Securities Dealers, and state securities regulators all have active probes underway. The SEC is investigating the major Wall Street houses, while Spitzer has more firms in his sights. And even though Merrill has signed a settlement with Spitzer, that case may not yet be closed. Regulators in South Dakota and Missouri say they may refuse to sign off on it--and at least two other states may join them. "My concern is that [the settlement] limits our ability to use our full arsenal of weapons to help Missouri investors," says Missouri Secretary of State Matt Blunt.

Labor unions are taking up the cause, too, using their vast pension funds as a big stick to beat up errant management. They're pummeling blue-chip companies such as Walt Disney, Johnson & Johnson, and Sara Lee to keep their execs from paying auditors for consulting work on the side. In January, Disney said it will no longer pay consulting fees to its auditor, PricewaterhouseCoopers, following pressure from the United Association of Plumbers & Pipefitters, which, along with other construction unions, controls a $215 billion pension fund. Union resolutions at shareholder meetings are getting more support from other institutional investors, winning 10 to 15 percentage points more of the vote this year than last, says Damon Silvers, associate general counsel at the AFL-CIO's office of investment. Sometimes, the mere threat of a vote seems to do the trick. The AFL-CIO withdrew shareholder resolutions it had filed after Goldman Sachs (GS
), Merrill (MER
), and J.P. Morgan Chase (JPM
) all agreed to break the links between the pay of their research analysts and the amount of investment-banking business they help generate.

But it's hedge funds that are fast becoming the true attack dogs of the new shareholder activism. Their goal is simple: to unlock shareholder value. At ICN Pharmaceuticals Inc.'s (ICN
) annual meeting on May 29, David L. Cohen, who runs Iridian Asset Management, an $11 billion hedge fund in Westport, Conn., along with David Winters of Franklin Mutual Advisers in Short Hills, N.J., staged a proxy fight. They wanted to win enough board seats to oust controversial Chairman Milan Panic. With the duo winning by better than a 3-to-1 margin, Panic announced on June 12 that he will retire at the end of the month.

Even growth investors are rolling up their sleeves in an attempt to whip companies into shape. Thomas F. Marsico, president and portfolio manager of Denver's Marsico Capital Management, which manages $12 billion, has been calling and writing executives, including Cisco Systems Inc.'s (CSCO
) John T. Chambers, pushing them to pay higher dividends and lighten up on their use of stock options. He wants companies to pay dividends to prove their earnings are real. Marsico says when he tells execs that their earnings are tainted because of tricky accounting, the companies shoot back that they are following GAAP. "Well, fine, but it's not acceptable to me, and I'm not going to pay for those earnings," he says.

Growing numbers of investors seem to agree--and they are beating down the stocks of some of America's biggest companies. Money manager Bridgewater Associates has created an index of 20 big companies whose books are littered with serial takeovers that breed opportunities for earnings games. That index of suspect stocks is down 31% this year, compared with an 11% loss for the S&P 500. Tyco International (TYC
), for example, which made more than 139 announced deals and has acknowledged hundreds more, is down 83% this year. In contrast, United Technologies, a conglomerate with a less rapacious appetite for acquisitions, is up 8%. "Wall Street wants simple stories and consistent results," says Louis Navellier, whose Navellier & Associates Inc. in Reno, Nev., manages $5 billion.

If proxy contests are a reliable measure, the new activism is here to stay. Shareholders are voting against management in record numbers. They have won majorities on issues ranging from executives' golden parachutes to poison pills 76 times so far this year, vs. about 70 for all of last year, says Patrick McGurn, vice-president at Institutional Shareholder Services. "It's [like] Barry Bonds hitting 90 home runs this year. It is setting a new standard," he says.

The most important business stories of the day.

Get Bloomberg's daily newsletter.

As a result, companies that once could fend off with ease changes execs didn't like are now in retreat. At Bank of America (BAC
), for example, a shareholder resolution to slash golden-parachute provisions for departing executives grabbed 50.7% of the votes cast, compared with 40.7% last year. And governance issues such as executive compensation and corporate integrity are now resonating among a surprisingly wide audience. Says Charles M. Elson, director of the Center for Corporate Governance at the University of Delaware, "My dean has come around five times with different proxies to ask my advice. He didn't do this before."

Public contempt for corporate misbehavior runs deep--especially as the market stumbles. Investors are mad as hell--and they're not going to take it any more. They're also not willing to wait. Not for Congress, not for snail-paced accounting-standard setters. And above all, not for CEOs who still don't get it.

By Emily Thornton and David Henry

With Mara Der Hovanesian and Marcia Vickers in New York, Geoffrey Smith in Boston, and Mike McNamee and Amy Borrus in Washington